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Bank Investing 101

Tips for the novice bank investor.

More than 1,000 banks trade publicly in the United States, and ferreting out which ones are good investments can be a daunting process. But it's worthwhile, given some of the attractive features of banks as investments: Their regulation adds an element of safety, earnings tend to be relatively stable, they often pay attractive dividends, and people who run them are often pillars of the community.

Whether it's a community bank or a money-center bank, the important thing is to keep an eye on a few basic measures: asset quality, earnings growth, reserve coverage, financial strength, market attractiveness, and relative valuation. With those things in mind, let's go over a few tips for the novice bank investor.

Asset quality: Who's that banker with the OREO?When a bank fails, it is usually a result of poor asset quality, so paying attention to assets is pretty important. The buzzwords here are nonperforming assets (NPAs), which are basically loans that are no longer earning interest or are more than 90 days past due. Most analysts also include other real estate owned (OREO for short), which is essentially foreclosed real estate.

The absolute level of NPAs is less important than how large NPAs are as a percentage of equity or assets. The median ratio of NPAs to assets for all publicly traded banks in the nation is currently just below 0.3%. A bank with a good NPAs-to-assets ratio is Alabama National Bancorporation(NASDAQ:ALAB), which stood at 0.15% on Dec. 31. If a bank has a figure that's much higher than average, be careful.

Earnings growth: your "get out of jail free" cardAbout 20 years ago, the head of Equity Research told me, "If you overpay a little in terms of the P/E ratio, a good growth company's earnings will eventually bail you out." He was right. The key is to find banks with a solid outlook for earnings and to watch out for nonrecurring items (gains and losses on securities, for example) that might temporarily boost earnings.

In addition to the absolute growth rate in earnings, you should consider a few crucial profitability measures. One of the better ones is core return on average equity (ROE, a metric that essentially eliminates nonrecurring items), which is about 10.8% for the typical U.S. bank. Bank of Hawaii(NYSE:BOH) had a core ROE of nearly 26% in 2006.

Reserves: covering your assetsA bank's reserves are its financial cushion to absorb losses from bad loans. The "reserve" is actually a balance-sheet account called "allowance for loan losses." Think of this as a big pail of water whose liquid level should never get too low. When a bank charges off a loan, water drips -- and sometimes gushes -- out the bottom of the bucket. Management replenishes the water through an income-statement expense called "provision for loan losses." So when charge-offs get high, or the reserve level gets too low, the outlook for earnings can quickly deteriorate because of the prospect of much higher provisions for loan losses.

The allowance for loan losses is often measured as a percentage of loans, though sometimes it is compared to the level of NPAs as well. The median ratio of the allowance for loan losses to loans is about 1.18% for all U.S. public banks. The higher the ratio, the more the protection. Horizon Financial(NASDAQ:HRZB) had a reserves-to-loans ratio of about 1.5% at the end of 2006.

Financial strength: avoiding capital punishmentIf the allowance for loan losses is the cushion against bad loans, a strong capital position is the cushion against everything else. Think of a bank's equity in the same way you would think of the equity in your house.

Here's the rub, though. Too much equity can pull down some key performance yardsticks, such as return on equity. So a bank should have a strong capital position, but not too much of one. The median ratio of equity to assets for U.S. banks is currently about 9.5%, while the median ratio for tangible equity to tangible assets is 8.6%. The second ratio is similar to the first, but it excludes intangible assets such as goodwill, which is created in many acquisitions. Watch out if either ratio falls much below 6%, especially if the bank's asset quality is not solid. IBERIABANK(NASDAQ:IBKC) has its capital at about the right level, with a tangible equity-to-assets ratio of 7.1%.

Market attractiveness: location, location, locationA rising tide carries all banks. One of the first questions I would ask you if you told me about a great bank investment would be, "Where is it?" It's a good question, because if a market is growing rapidly, just about everything else is likely to be better for the bank, from loan demand to asset quality. Market location has become all the more important given the amount of consolidation taking place in the industry. Banks in mature markets, for example, can often improve the value of their franchise by acquiring banks in high-growth markets. Erie, Pa., is an example of a mature market; Atlanta is a representative high-growth market.

In analyzing market attractiveness, I tend to focus on forecasts of population growth and median household income. For the nation, population growth is expected to be 7% from 2006 to 2011, while household income is currently estimated at roughly $51,500. In terms of markets, how does Beverly Hills, Calif., sound? That's where City National(NYSE:CYN) is based.

Relative valuation: champagne tastes on a beer budgetMost analysts tend to focus on two valuation parameters: price-to-forecast earnings, and price-to-book value. If you can't find price-to-forecast earnings, compare price-to-trailing-12-month earnings. With actual earnings, though, make sure there isn't a significant amount of nonrecurring income or expense -- such as gains and losses on the sale of securities -- or you may get a skewed number. You should also watch out for gains on the sale of mortgages, which are recurring but can vary drastically. Price-to-book value and price-to-tangible book value (remember, tangible equity excludes intangibles such as goodwill) are often used as well.

The median multiple of trailing-12-month earnings, excluding nonrecurring items such as security gains, is currently about 16.8 for the nation's banks. The median price-to-book value is 1.68, and the median price-to-tangible book value is 1.83. I also like to compare dividend yields, especially now that we have preferential tax rates on dividend income. SCBT Financial(NASDAQ:SCBT) trades at a below-average multiple of about 16.7 times trailing-12-month earnings.

ConclusionEach of the banks I've mentioned above compares favorably on most, if not all, of the measures I've discussed. And many -- including Conway, S.C.-based CNB, which also meets most of the criteria -- aren't widely known, unlike the behemoths like Citigroup and Bank of America(NYSE:BAC). If you are looking at investing in a different bank, you have a pretty good chance of making a sound investment if it passes most of these screens.